Question

Explain the preferred use of historical cost as the basis for recording property and equipment and intangible assets.

Answer 1

'Historical Cost' is a convention in accounting that requires assets to be recorded (valued) in the accounts of the business at their original purchase price, rather than at an inflation adjusted market value.

The advantages, from an accounting perspective, are:

• Objectivity: It ensures that the reports on the financial position of the business are objective and can be verified by independent documentary evidence, such as invoice, statement, cheque butt, receipt or voucher.
• Simplicity: It is a simpler and more cost effective method of asset valuation that does not require constant work, estimating the changing current market values of assets. It also makes the calculation of annual depreciation a far easier calculation than having to deal with constantly changing asset values.
• Conservative: It does not recognise or include in the accounts of the business, assets appreciation profits that have not yet been proven or secured by an actual current market sale. Valuation of assets by market value would open up the options for 'creative accounting' and the possibility of management distorting the actual results of the business for personal gain.
• Consistency: The historical cost convention is consistent with the broad goals and purpose of accounting which is primarily charged with accurately recording and reporting the past financial transactions of a business. While stakeholders use the financial reports as a means of evaluating the financial position and performance of a business and making predictions about the future, this is not accounting's primary purpose which deals only with recording the past facts.